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China's Banking Reform: The RemainingAgendaCharles C. L. Kwong aa School of Arts and Social Sciences , The Open University of HongKong , Kowloon, Hong Kong SARPublished online: 27 Jun 2011.
To cite this article: Charles C. L. Kwong (2011) China's Banking Reform: The Remaining Agenda,Global Economic Review: Perspectives on East Asian Economies and Industries, 40:2, 161-178, DOI:10.1080/1226508X.2011.585056
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China’s Banking Reform: The RemainingAgenda
CHARLES C. L. KWONGSchool of Arts and Social Sciences, The Open University of Hong Kong, Kowloon, Hong Kong SAR
ABSTRACT Since 1994, China has endeavoured to establish a banking system that works moreclosely to commercial principles by transforming the specialized banks (SBs) into state-ownedcommercial banks (SOCBs). However, lending decisions of the SOCBs were still determined bystate directives instead of profitability consideration. This paper argues that although the post-WTO banking reforms have accomplished staggering results, China’s SOCBs need an overhaul ofownership structure if China aims to develop a full-fledged market-based banking system. It alsoargues that the current banking reforms are not comprehensive enough to sustain China’s long-term economic development because there still remain noticeable capital constraints facing small-and medium-sized private enterprises, particularly those in rural areas.
KEY WORDS: Chinese banks, state-owned commercial banks (SOCBs), banking reform,ownership reform, rural finance
Introduction
A most remarkable feature of China’s banking system is its rapid transformation
from the one monopolized by state banks to the one with a wider range of non-state
banking institutions. The state-owned commercial banks (SOCBs) and their non-
state counterparts are now more responsive to market signals and discipline. A
considerable headway has been made in implementing key reforms in the banking
sector, which is evidenced by the banks’ improved balance sheets, enhanced corporate
governance and compliance with international best practices. The public listing of the
four major SOCBs represented a milestone in ownership reform in China’s banking
sector. This move exposed the state banks further to market forces and competition.
However, this paper argues that if the mission of China’s banking reform is to be
completed in developing a full-fledged market-based banking sector and thereby
sustaining the country’s long-term economic growth and development, a further
retreat of state influence is of vital importance. For instance, when the central
government initiated the RMB4 trillion stimulus package in 2008, state banks were
pressured by local governments to extend loans to key projects to maintain economic
growth. Not a small number of these projects finally turned out to be unmatched by
Correspondence Address: Charles C. L. Kwong, School of Arts and Social Sciences, The Open University of
Hong Kong, 30 Good Shepherd Street, Ho Man Tin, Kowloon, Hong Kong SAR. Email: clkwong
@ouhk.edu.hk
Global Economic Review
Vol. 40, No. 2, 161�178, June 2011
1226-508X Print/1744-3873 Online/11/020161�18
# 2011 Institute of East and West Studies, Yonsei University, Seoul
DOI: 10.1080/1226508X.2011.585056
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effective demand, which intensified the problem of overcapacity.1 More importantly,
it may cause recurrence of non-performing loans (NPLs) accumulation in the
banking sector.
The remaining agenda of China’s banking reform hinges on the difficulties facing
the SOCBs in resisting the practice of lending based on government pressure.
Without an overhaul of the ownership structure of the SOCBs, further improvement
on corporate governance and risk management will be implausible. However, it is
likely that central leaders are cautious to release control in the banking sector, which
is in line with the doctrine of socialist market economy endorsed by the third plenum
of the 14th Central Committee on 14 November 1993. The notion of socialist market
economy recognized an enlarged role of market and privatization in the course
of economic reform, but the state-owned sector would remain the mainstay of the
economy.2
Nonetheless, viewing from a wider perspective, a well functioned financial system
should be able to serve the whole economy in a balanced way. After three decades of
reform, the rural financial reforms are still lagging behind, thus creating the risk of
slowing down further rural development. Without an efficient financial market,
investment in rural industries and agricultural production will be inhibited, and the
effects of any further effort to enhance rural income will be very marginal.
The Pre-1994 Banking Reform: A Snapshot
The establishment of People’s Bank of China (PBOC) in 1948 marked the starting
point of the banking system under the People’s Republic of China (PRC) rule.
China’s banking sector during the pre-reform period was characterized as a mono-
bank system in which banks operated under a scheme of ‘‘Tong Shou Tong Zhi’’
(unified income and unified expenditure). All deposits from individuals and
enterprises, mainly state-owned enterprises (SOEs), must be held by the PBOC. All
loans to SOEs and state projects were extended by the PBOC. In a nutshell, the
PBOC became the centre of settlement for both deposits and loans. In conformity
with the centralist character of the planned economy, the top priority of the central
planners was not attached to efficiency consideration of the banking system.
During the initial stage of industrial development in the 1950s and 1960s, China
encountered severe capital shortage, which would have entailed high interest rates if
capital allocation was made by market mechanism. However, the mono-bank system
was to allocate financial resources with zero interest rate to fulfil state plans and to
ensure insulation from potential domestic and foreign influence. The repercussion of
the mono-bank system was far-reaching because interest-free loans led SOEs to
severe soft-budget constraints and moral hazard problems, resulting in massive NPLs
accumulated in the 1980s and the early 1990s.
Economic reforms in the late 1970s brought about decentralization of economic
activities and prompted diversification of banking institutions in the early 1980s.
They allowed a larger role of market in allocating resources and developing non-state
enterprises, mainly collective enterprises. The share of nominal industrial output by
SOEs decreased from 76.0% to 64.9% from 1980 to 1985 while that by collective
enterprises increased from 23.6% to 32.1%, an average annual growth of 18.7%
during the period (Guo, 2002). Expanding non-state sector was accompanied by
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mounting financial resources held by decentralized units including households,
enterprises and local governments. Further, the opening-up to the outside world
through foreign direct investment (FDI) and setting up of special economic zones
(SEZs) necessitated state-owned specialized banks (SBs) to deal with international
financial transactions. The amount of utilized FDI soared from US$1769 million in
1979�1982 to US$4291 million in 1983�1985.3 The highly centralized mono-bankingsystem in the pre-reform era could no longer accommodate the financial needs
brought about by the reform.
From 1979 to 1984, four SBs were reinstituted and they were separated from the
PBOC. The Agricultural Bank of China (ABC) was re-established in 1979 to handle
deposits and lending in rural areas. The Bank of China (BOC) was reinstituted under
the State Council in 1979 to manage the country’s foreign exchange. The People’s
Construction Bank of China (PCBC) (renamed as China Construction Bank in 1996)
was made subordinate to the State Council in 1979 to finance construction and fixedassets investment while the Industrial and Commercial Bank (ICBC), established in
1984, specialized in funding business activities (Lardy, 1998; Okazaki, 2007). On top
of reinstituting the SBs, the central government transformed the PBOC into a formal
central bank in 1984 by transferring its deposit and lending activities to ICBC. The
re-establishment of the SBs and the setting up of a formal central bank laid the
important foundation of separating central bank and commercial bank functions.
The central bank, PBOC, has since then become the main government agency for
manoeuvring monetary policy, supervising the financial sector and fine-tuning themacroeconomy.
Aside from re-establishing the SBs, new commercial banks and non-bank financial
institutions (NBFIs) were allowed to open to cater for different financial needs in
urban and rural areas. Nine national and regional banks, such as the Bank of
Communications (BOCOM) and the Guangdong Development Bank, were set-up in
the 1990s. NBFIs also flourished in the decade. Up to 1994, about 60,000 rural credit
cooperatives (RCCs), 1500 urban credit cooperatives (UCCs) and 590 trust and
investment companies (TICs) were set-up (Chai, 1997). SBs’ specialized roles havestarted to blur since the 1980s and each SB has faced increasing competition from
other SBs and the new financial institutions.
The reinstituting of SBs and the diversification of financial institutions in the 1980s
represented only a hierarchical and structural transformation. Though with minimal
competition, the SBs still dominated the banking sector. The market share, in terms
of assets, of the four SBs (i.e. the Big Four) was 85.4% in 1988 and fell slightly to
84.2% in 1993 (Chen et al., 2000) and continued to perform the fiscal functions
assigned by the central government. SBs were expected to extend loans to SOEs eventhough many of the state enterprises were loss-making. The soft loans were to
maintain the operation of the enterprises by which stable employment could be
guaranteed.
The 1994 Banking Reform: Commercialization and Recapitalization of SBs
Commercialization of SBs
During the pre-reform period, SBs had been government policy agents to finance
state projects and SOEs. The primary problem associated with policy lending is that
China’s Banking Reform 163
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loans were extended to state entities on the basis of social and political consideration
instead of profitability and business criteria. Prior to the mid-1990s, the financial role
as fiscal agents assumed by the SBs remained basically intact. To avoid massive
layoffs by ailing SOEs, the SBs shouldered the key responsibility of rendering ‘‘soft
loans’’ to SOEs from the pre-reform period to the mid-1990s to maintain the
operation of many loss-making SOEs. In 1997, almost 40% of SOEs incurred
operating losses, rising from 19% in 1978. The total losses accumulated from
RMB4.2 billion yuan in 1978 to RMB74.4 billion in 1997, representing a spectacular
growth of 17.7 times (Wolf et al., 2003). The ratio of NPLs of the SBs reached 20.4%
in 1994 and was estimated to increase by 2% annually (Lardy, 1998).The PBOC lacked effective means of controlling the lending behaviour of the SBs,
which were dominantly affected by central directives. The ‘‘soft loans’’ resulted in
spectacular rise in money supply and inflation rates. Money supply (M2) increased
from 31.3% in 1992 to 34.5% in 1993 while the inflation demonstrated a hyper growth
from 6.4% in 1992 to 24.1% in 1994.4 The runaway inflation alarmed the central
leaders the possible macroeconomic instability resulting from quasi uncontrolled
bank loans by the SBs. On the other front, since the transformation of the General
Agreement on Tariffs and Trade (GATT) to World Trade Organization (WTO) in
1995, China started to request its membership in WTO. As part of the commitments
to WTO accession, China was required not only to reduce its tariff and non-tariff
barriers for imports but also to open up its telecommunication, banking, financial
and insurance sectors to foreign investors (Okazaki, 2007).
Facing both domestic and external pressures on its banking sector, the central
government embarked on an overhaul of the banking system in 1994 aiming at
developing the PBOC into an independent full-scale central bank to regulate the
banking sector and maintain macroeconomic stability. The Law of the People’s
Republic of China on the People’s Bank of China (PBCL) was enacted in 1995 to
establish a legal foundation for the superior status of the PBOC. The PBCL stipulates
that the PBOC, under the leadership of the State Council, devises and implements
monetary policy and monitors the operations of the financial sector (Article 2).
Article 7 of the PBCL entrusts the PBOC with a high level of independence by
specifying that the PBOC is free from the intervention of local governments,
government departments, organizations and individuals when it performs its central
bank functions. The central government’s decision explicitly urged the establishment
of a ‘‘sound macroeconomic control system’’. It was clearly stated that ‘‘the central
bank, the PBOC, under the leadership of the State Council, should implement
monetary policy independently’’. The independent status was further elucidated in
that ‘‘the power of the central bank and local authorities over economic adminis-
tration should be rationally delineated’’ and ‘‘the branches of the PBOC are certified
as agencies of its head office (Mehran et al., 1996, p. 2; PBCL 1995)’’.
However, it is worth noting that the independence of PBOC in policy-making and
implementation should not be overemphasized. Under China’s socialist market
economy, the PBOC is subordinate to the State Council. The Governor of the PBOC
is nominated by the State Council Premier and endorsed by the National People’s
Congress. The Governor is then appointed by the President of the State. Further, the
drafting and implementation of budget of the PBOC are monitored by the financial
department under the State Council (Article 38 of PBCL 1995). The independence of
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the PBOC is merely in relation to local governments and government departments,
but not the State Council (Leung, 1998).
In dealing with the mounting NPLs, the banking sector overhaul took a decisive
step to commercialize the four SBs by separating commercial lending from policy
lending (World Bank, 1996; Lo, 2001). It was endorsed in the Third Plenum of the
14th Central Committee that the four SBs would gradually be transformed into
SOCBs. Policy-based loans are designated to the three policy lending banks
established in 1994.5 By doing so, the SOCBs could be freed from the burden of
‘‘soft loans’’ and concentrate their businesses in commercial lending based on market
disciplines. However, the transfer of policy lending from the SOCBs to the three
policy lending banks was more complicated than expected. Two points deserve
mention. First, the newly established policy banks were reluctant to accept the policy
responsibilities, particularly lending to SOEs, previously assumed by the SBs. The
SOCBs continued to be a major government-directed funding source for SOEs.
Almost half of the short-term loans of SOCBs were extended to SOEs in 1997 (State
Statistical Bureau, 1998). Second, since the policy banks did not receive deposits
from the public, their operation was financed by state fund by issuing financial bonds
to existing financial institutions, primarily the SOCBs. The state banks were under
constant pressure and directives from the PBOC to absorb the financial bonds issued
by the policy banks.6 As a result, commercialization of state banks did not
substantially improve the balance sheets of SOCBs in the 1990s.
Commercializing the SBs in 1994 aimed at separating policy and commercial
lending, through which the efficiency of the state banks was enhanced. However, in
practice, the reform failed to institute a credit culture based on market disciplines.
Lending decisions were still mainly influenced by state directives instead of
profitability considerations. The reform was also constrained by a lack of Chinese
bankers well-vested with knowledge of running commercial banks (Chen & Shih,
2004). The rising fragility of China’s banking sector was evident by the escalating
NPLs in the 1990s. Some estimates indicated that the ratio of NPLs of the Big Four
stayed at an alarmingly high level of 40% by the end of 1998 (Woo, 2003). The Big
Four were technically insolvent in the late 1990s.
Recapitalisation of SOCBs
The banking reform efforts in 1994 failed to realize the present target of improving
the balance sheets of the SOCBs. The central government perceived the need of
strengthening the capital position of the Big Four before fulfilling the WTO
commitments of opening up the banking sector to foreign competitors. Further,
the Asian financial crisis in 1997�1998 crystallized into the central leaders’ views that
the ailing banking sector could be a destabilizing factor in the economy when China
had established increasing links with the global economy. To accelerate the pace of
repairing the balance sheets of the state banks, the Ministry of Finance (MOF)
injected US$34 billion into the Big Four to lower the NPLs in 1998. The
recapitalization was supposed to alleviate the financial burden of the SOCBs arising
from the past policy lending. Such recapitalization by the central coffers was planned
to be ‘‘first and final’’ (Anderson, 2008, p. 172). To offer a quick fix to NPLs problem
in the SOCBs, four asset management companies (AMCs) were established in 1999 to
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absorb RMB1.4 trillion of bad loans from the Big Four. Dai Xianglong, former
governor of the PBOC, described the AMCs’ absorption of bad loans as the ‘‘last
supper’’ of the SOCBs (Brahm, 2002).
Despite the massive AMC carve-out, NPLs remained at a startling level
immediately after China’s admission to WTO in December 2001. The NPLs ratios
of ICBC, BOC, CCB and ABC were at high levels of 25.4%, 23.37%, 15.17% and
36.63%, respectively in 2002 (Okazaki, 2007). The capital adequacy ratio (CAR),
a measure of the capital strength of a commercial bank, was still below the
international standard of 8% (Table 1). Central leaders realized the pressing need for
another round of bailout. Further recapitalization, amounted to US$75 billion, ofthe SOCBs in 2003�2006 defeated the initial design of a ‘‘once-and-for-all’’ relief plan
for China’s debt-ridden state banking system. Table 2 shows that by 2006, official
financial support provided for state banks amounted to US$402 billion.
Central government’s ongoing financial support successfully lifted the CAR of the
SOCBs to a level higher than the international standard of 8% (Hansakul, 2006)7 and
reduced the NPLs ratio to an official figure of 7.83% in 2007 (Q3�the third
quarter).8 The rapid drop in NPLs ratio was also attributable to the double-digit
credit growth since 2000. More importantly, the bailout of SOCBs only transferred
the financial burden from the state banks to the AMCs and other government
agencies such as the PBOC and the MOF, instead of instituting an effective
mechanism to solve the governance problems. In relative terms, the substantial
capital injection did not result in corresponding enhancement of the SOCBs’financial indicators. Compared with other Asian developing countries, China’s
NPLs ratio was higher than some neighbouring countries such as Indonesia,
Thailand and Malaysia in 2007 (Anderson, 2008). After rounds of recapitalization,
the NPLs ratios of the SOCBs have still consistently remained higher than their non-
state counterparts such as joint-stock commercial banks (JSCBs) and city commer-
cial banks (CCBs), and the national average in recent years (Table 3).
Though the SOCBs’ NPLs ratios have been demonstrating a steady decline, it is
worth noting that the amount of special-mention loans, referring to debts that may
turn into NPLs, increased by RMB35.8 billion in the first five months of 2008 to
RMB2.16 trillion, according to the China Banking Regulatory Commission (CBRC)
(Lagerkranser, 2008). The figure rose further by RMB54 billion during the period of
April�June in 2010, accounting for 3.91% of total loan assets (Shen & Wong, 2010).
There was only 6% of special-mention loans turning into NPLs in 2006 (Kudrna,2007), but it is likely that the special-mention loans may deteriorate to NPLs in
Table 1. Capital adequacy ratios of the SOCBs 1997�2002 (%)
Year ABC BOC CCB ICBC
1997 2.93 3.91 3.54 4.051998 8.13 11.74 9.31 10.401999 1.44 8.5 3.79 4.572000 n.a. 9.8 6.51 5.382001 1.44 8.3 6.88 5.762002 n.a. 8.15 6.91 5.54
Source: Okazaki (2007).
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coming years if shrinking corporate profits in some industries under global economic
downturn undermine the companies’ ability to repay debts. The possible rebound of
NPLs indicates that government bailout only alleviated the ‘‘stock’’ problems of bad
debts, but not the ‘‘flow’’ problem. Chinese banks are still in lack of adequate internal
governance and risk management mechanism to maintain a stable and acceptable
level of NPLs.
Other financial indicators further confirm the underperformance of the SOCBs.
For instance, from 2005 to 2006, the smaller CCBs, such as the Zhuzhou CCB and
the Bank of Dalian, achieved a much faster growth of profitability than the SOCBs
did (KPMG, 2007). These figures are consistent with the study by Yao et al. (2007),
which uses panel data of 22 Chinese banks from 1995 to 2001 to assess their
performance. The results indicate that non-state banks are 8�10% more efficient than
their state counterparts. The relative inefficiency of state banks was attributable to the
government protection while the non-state banks were facing a hard budget
constraint. Lin and Zhang (2009) reaffirm the findings by Yao et al. (2007). Based
on that data from 60 Chinese banks during the period 1997�2004, Lin and Zhang
reveal that the SOCBs were less efficient and profitable, in terms of return on asset
(ROA) and costs to operating income (COI), than the JSCBs, CCBs and foreign
banks. The underperformance of the SOCBs raises the issue of moral hazard and
cost-effectiveness of bailing out the state banks. It implies that the bailout has not
fundamentally changed the state banks’ corporate governance and lending practice.
Table 2. Official financial support to SOCBs 1998�2006
Item Date Amount (US$ billion) Source
Capital injection to Big Four 1998 34 Ministry of FinanceAMC carve-out 1999 5 Ministry of FinanceAMC carve-out 1999 48 People’s Bank of ChinaAMC carve-out 1999 120 People’s Bank of ChinaCapital injection to Big Four 2003�2006 75 People’s Bank of ChinaSubsidized NPL carve-out 2004�2006 100 People’s Bank of ChinaTax relief for NPL write down 2004�2006 20 Ministry of FinanceTotal 402
Source: Anderson (2008).
Table 3. NPLs ratios of banking institutions
2007 2008 2009
Commercial banks in total 6.2 2.4 1.6State-owned commercial banksa 8.0 2.8 1.8Joint-stock commercial banks 2.1 1.3 1.0City commercial banks 3.0 2.3 1.3Rural commercial banks 4.0 3.9 2.8Foreign banks 0.5 0.8 0.9
Note: aNPL figure since 2007 cover the Big Four and the Bank of Communications (BOCOM). BOCOM was
categorized as a SOCB in 2007.
Source: CBRC (2007, 2008, 2009).
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The Remaining Agenda
Commercialization and recapitalization of state banks have improved the SOCBs’
balance sheets in an impressive pace. However, the accomplishment is accompanied
by huge financial inputs provided by the central coffer. More importantly, the major
state banks are still under strong government influence in their loan decisions. Within
the framework of China’s socialist economy, despite the fact that banking reforms
were carried out to enhance banks’ efficiency to cope with the increasing competition
after its accession to WTO, it is unlikely that the central government will surrender itscontrol in the banking sector. The banking sector remains to be the main platform for
the Chinese government to fine tune and stabilize its macroeconomy. This point is
illustrated by the RMB4 trillion stimulus package, which is discussed in later section.
Though China welcomes foreign strategic partners to collaborate with their state
banks, it treasures more the foreign partners’ expertise on managerial efficiency,
corporate governance and risk control, rather than their participation in daily
operation and loan decision. Increasing foreign participation in SOCBs will
unavoidably undermine China’s autonomy in exercising macroeconomic policythrough the state banks.
Governance and Ownership Reform
Until the mid-1990s, the issue of corporate governance was irrelevant to the SOCBs
as their main duty was to channel funding to the SOEs and state project. SOCBs were
not accountable for profits and losses. As mentioned above, the ‘‘soft loans’’ extendedto the state sector led to the soaring of NPLs. Since the banking reform implemented
in 1994, effective governance of Chinese banks is essential to providing managerial
incentives for prudent lending, which is of primary importance to prevent
accumulation of NPLs. The most important step of strengthening banking super-
vision was the setting up of CBRC in 2003, which regulates all banks and depository
institutions. One of the major tasks of the CBRC is to ensure that the SOCBs are
operating under prudent commercial bank practices such as the 10-plus loan
classification system9 and the internal rating based loan system to evaluate thepotential risks of loans extended to the market (Hansakul, 2006). It is a vital step to
develop a lending practice among SOCBs to take into account the risk factor when
they make their loan decisions. However, Podpiera (2006) points out that the lending
behaviour of the SOCBs does not indicate fundamental changes. For the period
1997�2004, profitability of the enterprises did not appear to be the major
determinant for SOCBs’ lending decision. Rather, the findings of Podpiera reveal
that lending decisions by SOCBs were mainly determined by the growth rate of
savings deposits.Though China has fulfilled most of the 25 Core Principles adopted by the Bank for
International Settlements (BIS) committee on banking regulation and supervision,
some principles are not really de facto fulfilled. To illustrate, Principle 1 requires the
regulatory agency to have full autonomy, power and resources to exercise its
supervisory and monitoring role. However, the CBRC is hierarchically under the
State Council which can veto the decision made by CBRC and the appointment of key
officials in CBRC is still under the control of the Communist Party. The state banks
are also required to recruit independent directors to oversee the decision-making
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process and operation of the SOCBs, but most of the independent directors are either
government officials or ex-bank staff, who can rarely perform independent super-
visory role (Kudrna, 2007).
To bring in stronger outside governance and oversight to increase the state banks’
operation efficiency, three of the Big Four (ICBC, CCB and BOC) were listed on
stock exchanges in Hong Kong and Shanghai in 2005/2006 to allow more market
discipline to monitor their performance. After years of preparation and trimming
down the NPLs, the ABC was finally listed in Hong Kong and Shanghai in mid-2010.
Foreign strategic partners are now more welcome not just for their capital, but also
for their knowledge in bank practices, product design and international exposure.
However, the influence of foreign partners in the Chinese banks should not be
magnified since the ceiling of foreign ownership in a Chinese bank is 25% and the
ceiling of a single foreign bank holding share of a Chinese bank is capped at 20%.
The state remains the major shareholder of the Big Four (see Table 4). Except
BOCOM, more than half of the share of the Big Four is held by state departments
and agencies. The state shares in BOC, ICBC and ABC are maintained at a high level
of 70�80%. After several years of post-IPO operation, three of the Big Four SOCBs
have accumulated more experience in corporate governance and daily operation of a
large-sized listed commercial bank. When ABC prepared its public listing, it did not
invite any foreign strategic investor. Only a few smaller ‘‘cornerstone investors’’, such
as the Standard Chartered Bank, were solicited to subscribe the share, but not
participate in the operation of the ABC.10
In most cases, the major foreign investors are entitled to nominate one candidate in
the director board, usually consisting of 15�18 members (McGuinness & Keasey,
2010), of the state banks, but their role in key decision-making is more de jure than de
facto (Kudrna, 2007). The involvement of foreign partners in daily management is
marginal (Table 5). Though the state banks have tried to recruit foreign bankers to
join their senior management, this outside talent, in general, served in the state banks
only for a short period of time. Their inputs for improving the banking efficiency are
therefore very limited.11 Influence of foreign partners is substantially constrained by
the fact that top positions in state banks are still appointed by the party leadership
and the chairperson of a SOCB also serves as the party secretary of the bank (Brehm,
2008). Civil service appointees in top positions imply that state banks cannot be fully
insulated from government influence on lending decisions. The rationale of limited
foreign ownership and participation in bank operation is best captured by the
statement made by Chinese Premier Wen Jiabao on 14 March 2006:
The goal of reforming the state-owned commercial banks is to establish a modern commercial bank
system. . .The reform of China’s state-owned commercial banks must ensure that the state stake
takes a dominant share to control the economic lifeline and guard against financial risks.12
In response to recent queries from WTO members, China clearly indicated no plans
to increase the limits on foreign ownership of Chinese banks, given China’s stage of
development and the global financial instability.13 China’s reluctance in further
liberalizing its banking sector appears to be a reflection of China’s strong attachment
to its socialist market economy in which market forces are the means for resources
allocation, but state dominance in key or strategic sectors remains. State influence in
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Table 4. Pre- and post-IPOa major shareholders of SOCBs
Pre-IPOb Post-IPOc
State share Foreign strategic investor State share Foreign strategic investor
BOCOM Ministry of Finance (25.53)*NCSSFd(14.22)China Central SAFE InvestmentLimitede (7.68)
HSBC (19.9) Ministry of Finance (26.48)NSSF (11.34)
HSBC (19.15)
CCB China Central SAFE InvestmentLimited (71.13)China Jianyin Investmentf (10.65)
Bank of America (9.0)Tamasek (5.1)
China Central SAFEInvestment Limited (57.03)
Bank of America (10.95)Tamasek (5.81)
BOC China Central SAFE InvestmentLimited (79.90) NCSSF (3.91)
RBS China (9.61)Tamasek (4.81)
China Central SAFEInvestment Limited (67.49)NCSSF (4.46)
Tamasek (4.13)
ICBC Ministry of Finance (43.28)China Central SAFE InvestmentLimited (43.28)NCSSF (5.0)
Glodman Sachs (5.75)Allianz (2.25)American Express(0.45)
Ministry of Finance (35.3)China Central SAFEInvestment Limited (35.4)NCSSF (4.2)
Glodman Sachs (3.9)Allianz (1.0)American Express (0.2)
ABC China Central SAFE InvestmentLimited (50%)Ministry of Finance (50%)
NIL China Central SAFEInvestment Limited (40.03)Ministry of Finance (39.21)NCSSF (3.02)
Standard Chartered Bankg
(0.37)
Note: *Figures in the parentheses are the respective shares of domestic/foreign investors.aIPO � Initial public offering.bRefer to the share structure immediately before IPO (The dates of H-share listing for BOCOM, CCB, BOC, ICBC and ABC were June 2005, October 2005, June 2006, October
2006 and July 2010, respectively).cAs at 30 June 2009 for CCB, BOC, ICBC and 30 September 2010 for ABC.dNCSSF �National Council for Social Security Fund.eAlso refer as Central Huijin Investment Limited (Huijin).fChina Jianyin Investment was wholly owned by China Central SAFE Investment Limited.gABC did not invite strategic investors to participate in bank operation, but solicited several cornerstone investors to buy the share of ABC.
Source: ABC Third Quarter Report (2010); McGuinness and Keasey (2010); Thomas White Global Investing (2010).
17
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banking sector is still prevalent after the ownership reform, which was evidenced by
the RMB4 trillion stimulus package initiated by the central government in 2008 to
buffer the possible economic downturn amid global financial crisis. To reach the
investment targets delegated by the central government, local governments were
active in supporting local banks, mostly state banks, to extend loans to local
government financing platforms (LGFPs), which were mainly enterprises and
projects engaged in infrastructure and public utilities. LGFPs have strong tie and
support from the local governments and thus are able to acquire loans without much
difficulty. The loans in some sense can be interpreted as ‘‘local policy loans’’. Local
banks extended RMB3.1 trillion of LGFP loans, a 70.4% annual growth, in 2009,
which accounted for 32.3% of China’s loan growth for the same period (Jiang & Sun,
2010). The presence of ‘‘local policy loans’’ highlights that SOCBs’ commercial
interests are subordinate to broader political and socio-economic consideration.
The lockup period for foreign strategic ownership in China’s commercial banks
poses another constraining factor on foreign investors’ role as outside governance. In
theory, listing the SOCBs can discipline the bank performance by selling their shares.
However, in practice, foreign strategic investors were prohibited from selling their
state bank shares within three years, which restricted the exit right of the strategic
partners and undermines the market discipline on state banks.14 The lockup period
Table 5. Roles of foreign strategic investorsa in CCB, BOC and ICBC
Number ofmembers in
director board
Number of foreignstrategic investors in
director boardRoles played by foreign
strategic investors
CCB 17 one non-executivedirector for Bank ofAmerica
BA has seconded about 50personnel to assist in riskmanagement, corporategovernance and consumerbanking. Temasek concentratesassistance in staff training intreasury, SME credit andcorporate business. Strategicinvestors assume no dailymanagement duties.
BOC 17 one non-executivedirector for RBS and onefor Temasek
RBS provides support inwealth management andcorporate banking while UBSmainly offer assistance ininvestment banking andsecurity business. Strategicinvestors involve no dailymanagement duties.
ICBC 15 one non-executivedirector for GoldmanSachs
Allianz assist in insuranceproduct and business while BAaid in risk management,investment banking and creditcard business.
Note: aAs mentioned above, there is no foreign strategic investor in the ABC.
Source: Kudrna (2007) and McGuinness and Keasey (2010).
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was later extended to five years in 2009 to cushion possible impact brought about by
the global financial crisis on domestic banks. This move further limits the capability
of foreign strategic investors to act as effective outside governance by selling their
stakes in Chinese banks when the banks do not perform well. The findings of
Heffernan and Fu (2010) reconfirm the notion that corporate governance reforms
has so far generated very limited impacts on the performance of SOCBs. Usingempirical data of 76 Chinese banks, covering 95% of banking assets in China, from
1999 to 2006, it is indicated that neither the percentage of foreign ownership nor bank
listings has an apparent effect on performance, which is measured by economic value
added and net interest margin. A plausible explanation, as analyzed above, for the
moderate effects of ownership reform on bank performance is that foreign investors,
subject to multiple constraints, are unable to provide real inputs to improve corporate
governance in Chinese banks. Dominant state ownership in the banking sector
enables both the central and local governments to continue their discernible influenceon banks’ lending practice.
Rural Finance: The Underserved Sector
Three decades of rural economic reforms have changed the income structure of
China’s rural households. Apart from deriving income on farmland, non-farmactivities, mainly rural industry, have become another main source of rural income
since the mid-1980s. In 1985, farming generated 75.4% of rural household income
and the figures diminished to 43.9% in 2008. On the contrary, non-farm income has
been gaining its share in rural income from 24.6% in 1985 to 56.1% in 2008, which
indicates that rural residents have relied increasingly on non-farm activities to
maintain their income growth (Table 6).
In addition, the proliferation of rural industry in the 1980s and 1990s assumed an
important function of absorbing surplus labour released from the agricultural sector.Rural enterprises employed 30 million of workers in 1980 and the number skyrocketed
to 111.69 million in 1990, demonstrating a growth of 2.72 times during the 1980s
(National Bureau of Statistics of China, 2005). However, employment creation by
rural enterprises was impeded by the implementation of banking reform in 1994,
which aimed at commercializing the four SOCBs by separating commercial lending
from policy lending, unintentionally resulted in noticeable capital constraints facing
Table 6. Farm and non-farm income in rural China 1985�2008
Income fromFarming (yuan) (1)
Income from Non-farmActivitiesa (yuan) (2) (1)�(2)
(1)/(1)�(2)
(%)
(2)/(1)�(2)
(%)
1985 263.2 86.3 349.5 75.3 24.71990 456.0 201.4 657.4 69.4 30.61995 956.5 563.3 1519.8 62.9 37.12000 1090.7 1083.9 2174.6 50.2 49.82005 1469.6 1637.0 3106.6 47.3 52.72008 1945.9 2491.5 4437.4 43.9 56.1
Note: aTransfer income is not included in non-farm income.
Source: Calculated based on the data from ZGTJNJ (1986); ZGTJNJ, 2009 CD-ROM (Tables 9�20).
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the small- and medium-sized private enterprises, particularly those in rural areas.
Since the SOCBs were required to operate on commercial principles, 44,000 county
branches of SOCBs ceased to operate during 1998�2001 to cut operation costs.15
Since 2000, the ABC has retreated from sub-county areas and county branches
have now become the lowest management layer in the countryside (Zhang et al.,
2010). The ABC, which receives deposits mainly from rural areas, has shifted its
lending towards urban areas, which generates more promising returns. Loans
extended to township�village enterprises (TVEs) and private enterprises (PEs)
increased in absolute term from 1985 to 2008, but the share in total lending by
financial institutions demonstrated a decreasing trend (Table 7), which reached a
historic low of 2.16% in 2008. Compared with the output share of rural enterprises in
Gross Domestic Product (GDP), which maintained at about 25% since 2000
(Naughton, 2007; OECD, 2009), the negligible share of total lending acquired by
rural enterprises exhibited the difficulties of accessing credit in the countryside. The
enterprises have to utilize their accumulated profits to finance their production and
investment. However, rural enterprises face keen competition among flourishing
TVEs and the SOEs that have much more easy access to bank credit. Rural
enterprises are less likely to acquire ample capital to invest in product design and
quality improvement. The expansion of rural enterprises is thus constrained and it
impairs the ability of rural enterprises to absorb rural labour. The growth rate of
employment in rural enterprises has been decreasing since 1995 and negative growth
was recorded for two consecutive years in 1997 and 1998. Though the figure
rebounded to 4.5% in 2005, it tapered off once again in recent years (Table 8). As
rural household income relies more on non-farm activities, slow labour absorption by
rural enterprises inevitably mitigates rural income growth, which has direct bearing
on the level of rural consumption.
Since the retreat of SOCBs in the countryside, RCCs become the most important
financial institution in rural areas to meet the credit demand by the rural enterprises
and households. The merge of RCCs in recent years, however, further decreased the
number of county financial institutions. As of the end of 2007, the number of county
Table 7. Share of loans to rural enterprises 1985�2008 (billion RMB)
Total lending byfinancial institutions
Loans toagriculture Loans to TVEs
Loans to PEs and self-employed individuals
1985 643.09 41.66 (6.48)a 32.13 (5.0)b n.a.1990 1683.78 103.81 (6.17) 83.13 (4.94) n.a.1995 5398.90c 192.16 (3.56) 110.04 (2.04) n.a.2000 13548.37 488.90 (3.61) 606.08 (4.47) 65.46 (0.48)2005 30204.28 1152.99 (3.82) 790.18 (2.62) 218.08 (0.72)2008 53840.60 1762.90 (3.27) 745.40 (1.38) 422.1 (0.78)
Note: aFigures in parentheses are the respective share in total lending.bFigures from 1985 to 1995 were combined loan amount to TVEs, PEs and self-employed individuals.cFigures before 1995 were total lending from the four SOCBs while figures since 2000 covered all financial
institutions.
n.a.� not available
Sources: Calculated based on the data from ZGTJNJ (1991, 1996); ZGTJNJ CD-ROM (2007, Tables 20�2; 2009,
Tables 19�2).
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financial outlets dropped by 9811 or 7.3% since 2004, declining to a total of 124,000
outlets. Towns and villages are the most adversely affected areas. By 2010, almost 9%
of the 35,000 townships in China had no access to banking institution. About 60
million rural residents did not have ready access to banking services.16 Despite the
increase in deposit in RCCs, a rising amount of funds has been channelled out of
rural areas through depositing funds into the PBOC or purchasing bonds for which
the returns are more stable and less risky. Even with the repeated emphases by central
leaders on the importance of rural finance in rural development, the amount of loans
extended to agriculture and rural enterprises is still disproportionately small.
Banking reform since 1994 has focused on the institutional overhaul of banking
sector in urban areas. Rural financial reforms have so far lagged behind, thus creating
the risk of slowing down further expansion of rural enterprises and rural
development as a whole.
Concerted efforts have been made to ensure adequate financial services rendered to
the countryside. The China Postal Savings Bank (CPSB) was established in 2007 to
takeover the rural financial services previously provided by the post offices. The new
bank provides a network of 37,000 branches providing banking services, including
small loans to individuals, in rural areas.17 However, since the postal saving system
was not allowed to extend loans to rural households and enterprises until June 2006,
it is not certain whether the newly established CPSB can have adequate expertise in
credit and risk evaluation (Kwong, 2009). The lending capacity of the CPSB is also
limited by its asset size, which was only 30.4% of that of the ABC and 3.4% of the
total bank assets in China in 2009.18
Table 8. Growth of employment in rural enterprises 1990�2008
Workers employed in rural enterprisesa (million) Growth rate (%)
1990 111.69 19.21991 113.41 1.51992 124.87 10.11993 145.42 16.51994 148.84 2.41995 163.87 10.11996 173.67 6.01997 171.72 (1.1)1998 171.29 (0.25)1999 175.00 2.22000 168.93 (3.5)2001 169.02 0.052002 171.73 1.62003 175.87 2.42004 179.56 2.12005 187.61 4.52006 194.59 3.72007 199.49 2.52008 203.98 2.2
Note: aFigures include workers employed in TVEs, PEs and self-employed individuals. Figures in parentheses
represent negative growth rates.
Source: Calculated based on the data from ZGTJNJ (1991, 2005); ZGTJNJ CD-ROM (2009, Tables 4�20).
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In addition, the CBRC designed a plan to set-up 1294 new financial institutions in
rural areas over a three-year period (2009�2011) to cater for the escalating demand
for financial services in rural sector. Nevertheless, the response of local and foreign
banks has been lukewarm as the average size of each loan application in rural areas
remains small19 and more risky, which lowers the cost-effectiveness of processing
each loan application. Lending to rural areas has so far recorded a very highNPL ratio, which is almost three percentage point higher than the national average
(Table 9). Further, the lack of collaterals from farmers increases the default risks of
the loans. Lower profitability and higher risks deter the banks from taking bold steps
to tap into the rural business, particularly in poor regions. Setting up an extensive
credit-reporting system is a necessary step to allow lenders to better manage their
risks in rural lending by reducing information asymmetry,20 which enables financial
institutions to increase their lending to the underserved areas.
A further relaxation of interest rates charged by rural financial institutions canprovide adequate risk premium for the lenders, which induces more loans to risky
borrowers.21 Not withstanding, higher interest rates may deter farm households from
borrowing from financial institutions. Therefore, the problem of inadequate financial
services in rural China cannot be solved solely by market means. Government
initiatives, such as government-subsidized microfinance, tax exemption and conces-
sionary land rent for financial institutions, must be instituted to promote lending to
rural households and enterprises.
Conclusions
China’s accomplishments in banking reform have been staggering, particularly in
terms of reducing NPLs, lifting up CARs and enhancing internal corporate
governance. This can be attributable to central government’s financial supports
and the competitive pressure exerted by China’s WTO accession. However, the stateinfluence, either direct or indirect, on banks’ operation and loan decisions is still
prevalent. SOCBs are still outperformed by their non-state counterparts (e.g. JSCBs)
in terms of NPLs ratio and growth of profitability. The future success of China’s
banking reform relies on whether banks can truly operate according to market
principles such as profitability and repayability, which in turn rest on the extent of
state dominance in loan decision.
Central government leaders are still reluctant to surrender their controls to the
market, not to mention of foreign investors. Expanding market liberalization of
Table 9. Top five economic sectors with highest NPLs 2009
Economic sector NPL ratio (%)
Hotels and catering services 4.82Farming, forestry, animal husbandry and fishing 4.52Culture, sports and entertainment 3.24Scientific research, technical services and geologic prospecting 2.98Credit card 2.83National average 1.6
Source: CBRC (2009).
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China’s banking sector may weaken central government’s macroeconomic control,
though market reforms have brought substantial benefits to China’s SOCBs. China
will continue to try to strike a balance between liberalization and state control in the
banking sector. Viewing from the global financial turmoil in 2008, central policy-
makers will place financial stability on the top agenda and bold steps towards further
ownership reform are unlikely in the near future.On the other front, the lack of access to credit by farmers and rural enterprises
cannot be resolved merely by market solutions. Government’s policy initiatives, such
as tax exemption or concessionary land rents, are needed to provide local and foreign
banks with incentives to invest in rural areas. This is especially important in remote
regions. Without addressing the credit problems in the countryside, a stable and
sustainable income increase can hardly be achieved. Consumption level of rural
households will probably continue to lag behind their urban counterparts. China’s
banking reform would be far from complete without addressing the issues of
ownership structure and rural finance.
Notes1 For example, China produced 58 million tons of extra capacity in the first half of 2009 when global
demand was estimated to decline by 14.9%. ‘‘Overcapacity exacerbated by recession’’ (China Daily,
12 April 2010), Available at http://www.chinadaily.com.cn/bizchina/2010-04/12/content_9714677.htm
(accessed 2 March 2011).2 The Central Committee Plenum on 14 November 1993 endorsed a document, ‘‘Decisions on some
questions relating to the setting up of a system of socialist market economy’’. It is stated in the
document that: ‘‘. . .even if State property remains the main base of the national economy, all forms of
property � State, collective and private � will have to be used in developing the economy’’. See Fabbri
(2006).3 Author’s calculation based on National Bureau of Statistics of China (formerly State Statistical Bureau),
Zhongguo Tongji Nianjian 1985 (ZGTJNJ hereafter, China Statistical Yearbook 1985), (Beijing:
Zhongguo Tongji Chubanshe), p. 581.4 Author’s calculation based on the data from National Bureau of Statistics of China, 2003, pp. 313 and 704.5 The three policy lending banks are the Agricultural Development Bank of China, Export�Import Bank
of China and the State Development Bank of China.6 For example, the State Development Bank sold 77.5 billion yuan of financial bonds to beef up its capital,
42.9 billion yuan was sold to the SOCBs (Lardy, 1998).7 At end of 2005, the CARs of BOC, CCB and ICBC were 10.42%, 13.75% and 10.26%, respectively.8 Available at http://www.cbrc.gov.cn/english/home/jsp/docView.jsp?docID�2007051774830DBD1F200
10BFFD7F4A6791F6F00 (accessed 7 January 2008).9 It is a further refinement of the five-tier loan classification (i.e. performing loans, special mention loans,
sub-standard loans, doubtful loans and loss loans). For each tier of loans, it is further subdivided into
several levels (in general, from one to four levels) to better reflect the loan quality.10 Standard Chartered subscribed US$0.5 billion of the share issued by ABC (Hu & Zhang, 2010).11 Some analysts pinpoint that the short service term of the foreign bankers in China’s SOCBs may be due
to the culture shock in management style. It is difficult to verify the validity of this view, but recent
reports, at least, provide anecdotal evidence to support this view. See ‘‘Chan quits top BOCHK post
after two months’’, South China Morning Post, 5 March 2008, B8.12 Wen made this statement before the H-share listing of BOC on 1 June 2006. Quoted from ‘‘Chinese PM
says state must control reform of state-owned bank’’, Available at http://www.redorbit.com/modules/
news/tools.php?tool�print&id�427198 (accessed on 29 November 2010).13 ‘‘China defends foreign bank ownership limit at WTO’’ Available at http://www.news.alibaba.com/
article/detail/trade/100193619-1-china-defends-foreign-bank-ownership.html (accessed 13 December
2010).
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14 ‘‘China to extend lockup for banks’ foreign owners’’ Available at http://www.reuters.com/article/
idUSSHA25281320090401 (accessed 29 November 2010).15 For the impact of 1994 banking reform on rural enterprises, see Kwong and Lee (2005).16 See ‘‘China to improve rural bank access’’ Available at http://www.ft.com/cms/s/0/fa33053a-bc0a-11de-
9426-00144feab49a.html#axzz1AitAFvH7 (accessed 11 January 2010) and ‘‘Agricultural Bank of
China’s micro-credit loan program in rural areas expands rapidly’’ Available at http://www.english.
people.com.cn/90001/90778/7070266.html (accessed 11 January 2011).17 See also ‘‘China Postal Savings Bank wins approval to distribute insurance’’ Available at http://
www.forbes.com/feeds/afx/2008/08/06/afx5297723.html (accessed 9 June 2010).18 Calculated based on the data from Agricultural Bank of China 2010 Third Quarter Annual Report, p. 3
and CBRC 2009 Annual Report, p. 122.19 He (2008) indicates that average loan amount to rural households in low income province, such as
Guizhou, was only 4612 yuan according to a survey conducted in Guizhou in 2005.20 Credit information of 74 million rural household was recorded by 2007, which was about one-third of
China’s rural households (See Gale, 2009). The proportion of households is calculated based on the data
from ZGTJNJ CD-ROM 2007 (Tables 3�14).21 Since 2003, the government has allowed the RCCs to charge interest rate 2.3 times higher than the
benchmark rate set by the PBOC while the new rural financial institutions, such as rural commercial
banks, have been allowed to charge up to four times of the benchmark rate (Gale, 2009).
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